Bargain hunters have begun to pay close attention to emerging market stocks.
They are a little late to the game. After all, momentum-driven investors have already noticed that shares of companies based in rapidly growing economies like China and India came roaring back to life over the last year. Led by hot tech names such as Tencent Holdings and the Alibaba Group, many of them doubled in value in 2017.
But now value-minded mutual funds and exchange-traded funds are rummaging in the parts of the emerging markets that many have ignored — staid sectors like manufacturing, mining and finance. Even these parts of the emerging markets posted sizable returns over the last year as global economic growth started to reaccelerate.
But while the fast-growing segments of the emerging markets returned around 40 percent in 2017, the so-called value stocks rose about half as much.
The more muted returns, coupled with the five-year bear market in emerging market equities before this surge, mean emerging market value stocks are still trading at relatively attractive prices. Some bargain hunters say emerging market value stocks are the only truly undervalued part of the global equity market.
While the price-to-earnings ratio for the fastest-growing segments of the developing markets stands around 16, emerging market value stocks are trading at a P/E of just below 10.
“If you can buy a well-diversified equity portfolio with a P/E of 10, you’re getting an awful lot of earnings for each dollar of price you’re paying,” said Chris Brightman, chief investment officer for the asset management firm Research Affiliates.
Arjun Jayaraman, head of quantitative research and a portfolio manager at Causeway Capital Management, says emerging market value stocks are the only major asset class trading at a discount to their pre-global-financial-crisis levels. This explains why many value investors think these stocks will outperform in the coming years.
The asset management firm GMO, for example, forecasts that over the next seven years, emerging market equities in general will gain only 2 percent a year on an inflation-adjusted basis but value stocks will return nearly 7 percent annually.
There are risks, though, to the strategy of emphasizing value stocks in emerging markets. “When most people think about the demographic trends driving the emerging markets and the high growth rates of India and parts of China, these things are all favorable to growth” stocks, Mr. Jayaraman said — but not necessarily to value-oriented shares.
But, he says, “The rubber band can only stretch so far” when it comes to the rising prices of growth stocks.
Ernest C. Yeung, manager of the T. Rowe Price Emerging Markets Value Stock Fund, notes that in the low-inflation, low-interest-rate climate that much of the emerging markets have been mired in recently — where investors worry that growth will be hard to come by — “people are willing to pay up for future growth.”
“That’s why in this environment, high-quality growth stocks — names like Tencent and Alibaba — have done so well,” he said. But that should start to shift, he said. “When the macroeconomy recovers, value stocks normally begin to work.”
In particular, value stocks in the financial industry stand to benefit.
“Financials are a driven by the health of the macroeconomy and the direction of interest rates,” Mr. Yeung said. And they’re cheap.
Take Standard Chartered. While technically based in London, this $30 billion commercial and retail bank operates primarily in Asia, Africa and the Middle East, where the economy is growing at a much faster rate than in Britain.
“The bank has been through some rough times,” Mr. Yeung said. It posted losses in 2016, thanks partly to its holdings in the energy industry during a commodity slump.
As a result, the stock now trades at just 0.7 times the bank’s book value, which represents the net asset value of the company, compared with a price-to-book-value ratio of 1.5 to 2 before the global financial crisis. “So we are nowhere back to historical norms,” Mr. Yeung said.
The steel industry is another place that should thrive as the economy improves.
“The common perception is that China keeps dumping cheap steel into the global markets,” Mr. Yeung said. That may have been true several years ago, but the Chinese government recently carried out supply-side reforms that have reduced China’s steel supply more than 20 percent, he said.
As a result, Chinese exports have fallen more than 40 percent, creating breathing room — and opportunities — for other emerging market steel producers.
Mr. Yeung’s T. Rowe Price Emerging Markets Value fund owns shares of the South Korean steel producer Posco. The company gets about 90 percent of its revenue from developing economies in Asia. So the reacceleration of global growth in that part of the world is likely to be a tailwind for the stock.
Catherine LeGraw, a member of the asset allocation team at GMO, notes that investors need not limit themselves to staid industries to gain exposure to attractively priced emerging market stocks.
“Think information tech based in Taiwan instead of China,” she said.
Why? A number of Taiwanese tech companies are regarded as old tech because they are involved in the manufacturing and supply chain that propels new economy tech products and services.
These are companies like Hon Hai, whose subsidiary the Foxconn Technology Group helps manufacture Apple iPhones and Amazon Kindles, among other popular consumer devices.
Partly because Hon Hai is not regarded as a new economy name, the stock trades at a modest price-to-earnings ratio of around 10, compared with around 60 for Tencent Holdings, one of China’s largest internet and social media companies.
But Mr. Jayaram says that “if we see better sales for iPhones in the first quarter, that could be a big catalyst” to move Hon Hai’s stock, too. And that creates a buying opportunity for bargain hunters right now.